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Net Net: Promoting innovation and managing change

Short sellers see once in a lifetime opportunity—if they can survive

Hedge fund domino effect
Hedge fund domino effect

With the Dow Jones industrial average flirting with 16,000, hedge fund managers that focus on betting against stocks see a once-in-a-lifetime opportunity to make money on what they see as an epic equity bubble.

"This is it. It's the bottom of the ninth and we're about to hit a home run," said John Fichthorn, co-founder of Dialectic Capital Management and an expert on shorting stocks. "I believe this is the best opportunity I will see in my life as a short seller."

(Read more: Short seller John Fichthorn sees best opportunity in years)

Virtually every other so-called short-biased hedge fund agrees, practically jumping up and down to alert investors of the opportunity to make money when the stock market falls significantly.

The question, of course, is when and if the managers can survive as businesses long enough to see the big returns they are so convinced are coming.

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Several hedge funds that focus on betting against the market have decided to shut down recently. They include Russell Faucett's Barrington Partners, Jaime Lester's Soundpost Partners and, as previously reported, Marc Andersen and Eliav Assouline's Axial Capital Management, a Tiger Management seed.

(Read more: Julian Robertson offshoot crushed by rising market)

Faucett, Lester and a representative for Axial declined to comment.

The average short-biased hedge fund is down 16.87 percent this year through October, according to institutional investment data provider eVestment. The funds gained an average of 10.40 percent in 2007 and 31.97 percent in 2008, but lost 22.81 percent in 2009, 12.94 percent in 2010 and 13.17 percent in 2012 (they did rise 1.21 percent in 2011).

"The past several years have been challenging for short-biased funds, owing primarily to quantitative easing and the resulting surfeit of liquidity-creating valuation distortions," said Scott Schweighauser, president and portfolio manager at $9 billion fund of hedge funds Aurora Investment Management.

"That being said, Aurora believes that investors are now incorporating the view that QE will soon diminish, and are, therefore, recalibrating their own expectations with more realistic cost-of-capital assumptions," added Schweighauser, a longtime short allocator.

"We think that this will lead to robust dispersion amongst equities, and great alpha opportunities for investors' long and short portfolios. We are seeing much better returns coming from our short-biased managers in the last six to eight weeks, reflecting this new market dynamic."

Beside poor performance, short-biased hedge funds were slammed by the collapse of one of the their biggest allocators: Common Sense Investment Management.

Virtually all investors fled the once-$3.2 billion fund of funds Common Sense after the arrest of founder Jim Bisenius for soliciting a prostitute.

Common Sense was forced to request its money from all its hedge fund managers by year-end as a result of its investors requesting their capital back. Common Sense had for years been a top allocator to short-biased hedge funds and earned a reputation for thoughtful selection of hedge fund managers, especially small short-biased start-ups hungry to prove themselves.

Common Sense had money with the three firms shutting: Axial, Soundpost and Barrington, according to people familiar with the situation.

Time to get short?
Time to get short?

And the Portland, Ore.-based firm also had money with many remaining short-focused firms, including Fichthorn's Dialectic, Matt Kliber's Gracian Capital and Dave Davidson's SC Management, according to the people.

"Common Sense was the straw that broke the back of the marginal short-selling fund. They were the most thoughtful guys left in the fund of funds space in terms of allocating to smaller short-focused managers," said one of the fund managers who Common Sense redeemed from.

Davidson had Common Sense as a client since 2004 and, like others, lamented the fallout from the personal transgressions of one individual. "They're great investors with a great team," he said.

Common Sense did not respond to a request for comment.

(See also: Investors flee fund after founder's prostitution bust)

Shorting has also been a brutal game of late. Two of the most high-profile bets against companies—Pershing Square Capital Management's short of Herbalife and Greenlight Capital's move against Green Mountain Coffee Roasters, appear to have lost both firms significant money on paper so far.

Some of the most heavily shorted stocks have even outperformed equity indexes this year. They include Tesla Motors, Chipotle Mexican Grill, Netflix and Best Buy.

While shorts have been costly, many hedge fund managers have performed well by putting more money in their longs than their shorts. For example, David Einhorn's Greenlight is up 11.8 percent for the year through September and Bill Ackman's Pershing Square is up 8.1 percent through October despite its short losses.

Performance for the largest short-biased hedge fund firm, Jim Chanos' $6 billion Kynikos Associates, was unavailable. The firm didn't respond to requests for comment.

Another firm that has done well is Kerrisdale Capital Management. Sahm Adrangi started the firm in July 2009 with less than $1 million and made his name shorting Chinese companies like China Education Alliance and Advanced Battery Technologies.

The firm now manages approximately $300 million and is up about 20 percent this year through mid-November, according to an investor. The fund has been an average of 80 percent net long this year, according to Adrangi.

"I think shorting is a difficult way to make money over the long run. It can be done but it's a tougher way to generate wealth over the long term in most markets, especially over the last four years," Adrangi said.

Despite the struggles, short-focused managers couldn't be more excited about the opportunity.

"The quantity and quality of short signals, especially in large caps, have not been this robust since late '06 or early '07—the period that preceded the last recession," said Kliber of Gracian, which focuses on large companies to avoid the high cost of borrowing associated with many shorts. "The evidence of revenue strain and earnings risk among large companies is not fully reflected in consensus estimates."

Another is Davidson of $50 million SC Management.

"Since the 2009 lows, we're in (Fed Chairman Ben) Bernanke's grand experiment of QE, which hasn't created the job or wage growth desired. Financial assets have benefited, but now it's time for investor caution," said Davidson.

His fund is down 25 percent this year but gained 55 percent net of fees from 2000 to 2012, including a return of 59 percent in 2008.

Fichthorn of Dialectic echoed those themes. "You don't see these price to sales multiples on unprofitable businesses ever in history," he said. "It's a bubble—regardless of what the (Fed Open Market Committee) says. After all, they missed and/or caused the last three bubbles."

"Everything would give you the indication that shorts are being forced out of the market just as we're going through the second Internet bubble," Fichthorn added. "Social media, three-dimensional printers, service software businesses, Chinese Internet companies, you name it—the valuations are completely unsustainable and disconnected with reality, which presents an amazing opportunity for the patient short seller."

At least one manager is launching a new short-focused hedge fund. Bill Fleckenstein shut a short-biased fund in 2009 because he believed the shorting opportunity was over, but now plans to launch a fund in early 2014 with Wesley Golby, formerly a portfolio manager at S Squared Technology.

"Once the markets begin to react to consequences of all this money printing, then it will be like shooting fish in a barrel from the short side," Fleckenstein said.

Fleckenstein said companies in sectors like three-dimensional printers and social media are drastically overvalued. He believes that a good indicator for the beginning of a market correction will be when 10-year U.S.Treasury note yields rise to 3 percent from their current level of about 2.69 percent.

It's not clear what investors think.

Some say alternative investors are still bullish.

"The current mood among professional investors remains decidedly risk-on," said Daniel Celeghin, a management consultant on alternative investing with Casey Quirk. "Dedicated equity short-selling strategies have not been too popular, as most investors prefer to pay a premium fee for managers who make the timing call for them, and not for a fairly static market exposure."

That irks short sellers. "It's shocking to me that long-term investors aren't taking a long-term view of their books," said Fichthorn. "No one is positioned for a down market. You can see it in exposures."

One indicator of that risk-on mindset is the recent launch of various long-only private funds from Tiger Global and Coatue Management, for example.

(Read more: Tiger Global launches long-only fund)

Others think investors are finally warming to short sellers. For example, data tracker eVestment has slightly more money flowing to short-biased hedge funds in recent months, a reversal from outflows for the rest of the year.

"Anyone with a brain I think can tell that there's a tremendous opportunity setting up on the short side," Fleckenstein said. "Exactly when that's going to happen and will you be able to capture it well are different issues. But there's just no doubt about it. If you think that all this is all going to end well and there isn't going to be a spectacular collapse at some point in the coming year, plus or minus, then you really are naïve."

Dialectic—which manages almost $600 million overall with about half in a short strategy—was up 37.9 percent in 2008 and 21.36 percent in 2011 but fell 26.29 percent in 2012 and is down 21.13 percent this year through October, according to a person familiar with the fund. Dialectic declined to comment on its returns.

As the equity markets continue to hit record levels, time will tell if the shorts are right and if investors believe them.

"Short selling as a strategy is like an umbrella," Gracian's Kliber said. "People don't think they need one until it starts to rain and they get wet."

—By CNBC's Lawrence Delevingne. Follow him on Twitter @ldelevingne.